Chapter 7: Bonds.
Bonds are negotiable long-term debt obligations issued for periods of more than one year that represent a promise by the issuer to pay periodic interest at a fixed rate (i.e., the coupon) and to repay loan principal at a specific maturity date. (Zero coupon bonds are an exception to the periodic interest payment characteristic included in this definition.) Payment of both interest and principal to corporate bondholders takes precedence over payment of dividends to preferred and common stockholders. Unlike stocks, bonds do not give the investor an ownership interest in the entity that issues the bond. Because they provide for payments at specific rates and upon determined dates, bonds are referred to as fixed-income securities. In contrast, stocks are referred to as equity securities.
Notes. Except for their maturity dates, there appears to be no generally accepted distinction between corporate bonds and corporate notes. For example, the term "note" was used to describe zero coupon senior securities of the Pharmaceuticals Corporation due in 2032. (1) When a distinction is made, notes are of a shorter duration than bonds (see the discussion of a bond's "term" on page 96).
Securities. Securities are financial instruments that establish ownership of either debt or property. This debt or property can take the form of bonds (debentures) that demonstrate loans to a company, municipality, or government; stocks that demonstrate current ownership of a corporation; or options, rights, and warrants that demonstrate the right to a future ownership interest. Although these instruments have traditionally been physical documents, the introduction of electronic record keeping has resulted in their being increasingly replaced by electronic documentation (this is referred to as "book-entry"--see page 93).
Bond Classifications. It is helpful to categorize bonds according to the entities that issue them. Marketable bonds can generally be classified as: corporate bonds; municipal bonds; Treasury bonds, notes, and bills; and agency bonds. In contrast, U.S. Savings Bonds are not considered marketable bonds. See the Bond Matrix on page 92.
Bond Matrix (2) Referred To As Characteristics See Pages Corporate Corporates Taxable--par 105-110 Bonds/Notes value $1,000-- maturity periods vary from 1 to 20 years and up - varying amounts of risk, but highly rated bonds are generally considered low risk. * Municipal Munis Exempt from 120-123 Bonds federal taxes, sometimes exempt from state and local taxes -par value $5,000 and up - maturity periods vary from 1 to 20 years and up - some risk. Treasury T-Bonds Exempt from 111-112 115 Bonds state and local taxes - par value $100 and higher -maturity period is over 10 years up to 30 years - no credit risk. Treasury T-Notes Exempt from 111-112 117 Notes state and local taxes - par value $100 and higher -maturity periods vary from 2 to 10 years - no credit risk. Treasury T-Bills Exempt from 111-112 116 Bills state and local taxes - par value $100 and higher -maturity periods 4, 13, 26, and 52 weeks - no credit risk. Agency Ginnie Maes (GNMA) Ginnie Maes, 123-124 Securities Fannie Maes (FNMA) Fannie Maes, Freddie Macs (FHLM) and Freddie Many Others2 Macs are subject to federal taxes, other federal agencies are exempt from state and local taxes - par value $1,000 to $25,000 and up - maturity periods from 1 month to 20 years - slight credit risk. U.S. Savings Series EE/E Series I Are not 118-119 Bonds marketable. Federal taxation varies, but subject to state and local taxes -issued in amounts of $50 to $10,000 -maturity periods vary from 17 to 30 years -no credit risk. * Risk refers to default risk. All bonds are subject to varying amounts of other risks, including call risk and interest rate risk (see page 16).
BUYING AND TRADING BONDS
Bonds are purchased and sold in a variety of ways, depending upon the type of issuer and whether the bond is a new or outstanding issue. New bond issues are sold or auctioned on the initial-issue market and can be subsequently resold on very active (and dynamic) secondary markets. In fact, bond trading in the secondary markets tends to have a very direct impact on the coupon rates for newly issued bonds (see page 94). The following table provides a general summary of these markets.
Where Bonds Are Traded New Issues Outstanding Issues Corporate From brokers or Through brokers, on Bonds/Notes underwriters, on an an exchange or OTC. * exchange or OTC. * Municipal From brokers. Through brokers. Bonds Treasury From brokers. Can Through brokers. Can Bonds/Notes also be purchased also be sold through the Treasury TreasuryDirect (see through below SellDirect[R] program. Treasury Bills Sold by auction; Through brokers, on individual investors an exchange or OTC. * submit noncompetitive bids (see page 94). Can also be purchased through TreasuryDirect. Agency Bonds From brokers, OTC or Through brokers, OTC banks. or banks. U.S. Savings From commercial Not resold (i.e., Bonds banks, brokers, and savings bonds are by payroll not marketable). deduction. Can also be purchased through Treasury Direct. * Major exchanges that trade bonds include the New York Stock Exchange and the NASDAQ. See also, the discussion of OTC (over-the-counter) on page 58.
Commercial Book-Entry System. In the commercial book-entry system, the investor maintains a relationship with a financial institution, broker, or dealer and typically pays a fee for their services. Unlike TreasuryDirect, the commercial book-entry system allows investors to use their securities for collateral and to hold zero-coupon Treasuries (see STRIPs, page 113). Securities can be easily transferred between TreasuryDirect and the commercial book-entry system.
TreasuryDirect. TreasuryDirect is a program that allows investors to purchase Treasury securities directly from the U.S. government, rather than through a bank or broker. The program is intended for investors who buy securities at original issue and hold them until maturity. TreasuryDirect makes payments by direct deposit to the investor's bank account and sends statements directly to the investor. No fees are charged for opening an account or buying securities, but a modest maintenance fee is charged if an account has a total par amount of more than $100,000. TreasuryDirect also allows the investor to automatically reinvest the proceeds from most maturing securities. Financial institutions, government securities brokers, or dealers can submit a bid for a security to be delivered to TreasuryDirect for the investor.
Noncompetitive Bidding. There are the two types of bidding for a Treasury security. When bidding for a Treasury bill, note, or bond, the bidder must choose whether to bid competitively or noncompetitively. If a noncompetitive bid is placed, the Treasury guarantees the bidder will receive the desired security. By bidding noncompetitively the bidder agrees to accept whatever rate or yield is determined at the auction. Investors who don't consider themselves expert securities traders usually bid noncompetitively. A competitive bid is one where the bidder specifies the rate or yield he will accept, and the Treasury may reject the bid or grant it in less than the full amount.
Call Provision. Also referred to as a "call feature," this provision allows the issuer to redeem, or "call," the bond before the bond's redemption date. Bonds are most often called when the prevailing interest rates have dropped significantly since the bonds were issued. See also, "Yield To First Call" on page 103, and "Callable Bond" on page 105.
Coupon Rate. This is the stated rate of interest that is to be paid during the term of the bond. For example, a $1,000 bond that has a coupon rate of 7% pays annual interest of $70, usually at a frequency of $35 every six months. The term is derived from the coupons that were once attached to bonds, which were then clipped and submitted to the issuer (or the issuer's agent) in order to receive interest payments. Such bonds were also referred to as bearer bonds because the bearer of the bond had physical possession of the attached coupons and was, therefore, entitled to the interest payments. Today, bearer bonds, or coupon bonds, are no longer issued. As with stock certificates, bond certificates have given way to the computer age, with virtually all new bond issues, called book-entry bonds, being electronically registered. However, the term "coupon rate" continues to be widely used in describing a bond's interest rate.
Credit Default Swap. Bondholders can purchase a credit default swap (CDS) to protect themselves from the risk of default (i.e., as a hedge against risk). A CDS is a contract in which the buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff from the seller if the bond goes into default. By this means, the risk of default is transferred from the holder of the bond to the seller of the swap. CDSs were first used by banks to shift the risk of loan defaults to a third-party, thereby reducing their reserve requirements (and thus enabling them to make even more loans and more money). CDSs are also used for pure speculative and sophisticated arbitrage transactions involving an entity's credit quality. When used this way the speculator or arbitrageur often has no interest in the underlying entity (i.e., in the company whose creditworthiness or stock value is being monitored). Unlike insurance companies, the protection seller is not required to maintain minimum capital requirements for paying claims. Such activities are currently unregulated.
"Fallen Angel." This term is generally applied to an existing bond issue whose investment rating has been downgraded because of deterioration in the issuer's financial condition (see Bond Risk & Ratings, page 103). Typically, the reduction in market price, or value, of a fallen angel reflects the downgrade by a rating service from investment grade to speculative grade (see also Junk Bond, page 106). In contrast, a rising star is a bond whose rating has been increased as a result of improvement in the issuer's credit quality.
Floating An Issue. This is the process of initially offering a bond issue to investors for a specific period of time and at a specific rate of interest. Not all initial offerings float--some sink, as did the issue by Trump Hotels & Casinos in May of 2002. (3)
Indenture. Also called the bond agreement, bond covenant, or deed of trust, this is the written agreement setting forth the bond terms, such as maturity date, interest rate, and callability. A failure of the issuer to meet the contractual terms of the bond indenture results in a default of the bond issue.
Issuer. This is the entity, such as a corporation or municipality, that borrows funds from investors by selling bonds, and that has the legal obligation to make timely payments of both interest and principal as set forth in the bond indenture.
Original Issue Discount (OID). This is a bond that is originally sold at a discount from its face amount. For bonds issued after May 27, 1969, this discount is taxable over the life of the bond, even though there has been no cash payment. (4) Although bonds issued with original issue discount can also pay interest, zero-coupon bonds are the ultimate example of original issue discounting--they pay no interest until maturity (see page 107).
Par Value. Also referred to as the nominal, face, or maturity value, bonds are usually issued with a par value of $1,000, representing the principal, or the amount of money borrowed. If a bond is selling at par it is worth the same as its original issue value. In contrast, a bond selling at a premium is selling for more than par, and a bond selling at a discount is selling for less than par (see page 98). (A bond priced at 105 means $1,050.)
Sinking Fund. Not all bond issues have sinking funds, but when they are established it is for the purpose of annually paying off portions of the bond issue prior to maturity. The specific bonds to be retired are typically selected by lottery. Use of a sinking fund to retire debt over time can benefit the bondholder by reducing the risk of default. However, sinking fund redemptions can work to the bondholder's disadvantage by enabling the corporation to retire at par bonds whose market price is in excess of par.
Spread. Although used in many different ways, with respect to bonds this term is most often used as follows. Spread-to-Treasury compares the yield on the bond with the yield on a Treasury security of comparable maturity. For example, the spread between a 10-year Treasury bond yielding 4.80% and a 10-year corporate bond yielding 5.25% is 45 basis points. Referred to as a yield spread, it is expressed in terms of basis points, with 100 basis points being equal to 1%. The term is also used to describe a dealer's spread, or profit, on a bond transaction (e.g., the difference between the price paid to the issuer and the price obtained from the first holder of the bond). Lastly, the bid-ask spread is used as a measure of the liquidity of a bond. A small spread, or "gap," with more actively traded bonds provides greater liquidity and indicates a lower liquidity risk. As the spread rises on less actively traded bonds, so does liquidity risk. A large spread between what buyers are bidding and sellers are asking indicates a higher liquidity risk (see page 17).
Term. A bond's "term" is the number of years that must pass before the issuer redeems the bond; it is a function of the bond's maturity date. For example, a bond issued in 2002 with a maturity date in 2032 has a 30-year term. Again, there appears to be no general agreement as to the specific lengths of short-term, medium-term, and long-term notes or bonds. The following definitions of corporate notes and bonds have been used by the Bond Market Association: (5)
(1) Short-term notes--maturities of up to 5 years.
(2) Medium-term notes/bonds--maturities of 5 to 12 years.
(3) Long-term bonds--maturities greater than 12 years.
PRICES & YIELDS
The market price, or value, of a bond is a function of three factors: (1) the annual payment (coupon rate); (2) the number of years to maturity; and (3) prevailing market interest rates. The essential consideration is, "What is an investor willing to pay today for a future stream of income (i.e., the interest payments), plus eventual repayment of the bond principal?"
Yield Curve. This is a graph that illustrates the relationship between interest rates and maturity dates for securities of equal risk. For example, the yield curve will often compare the return on short-term Treasury bills with the return on 30-year Treasury bonds.
The sample yield curves, above, compare the relative yields of different Treasury issues. The vertical axis is percent, and the durations illustrated are 90-day, 180-day, and 1, 2, 3, 4, 5, 7, 10, 15, 20, and 30-years.
Yield curves are also used to compare the relationship between interest rates paid on short-term and long-term bonds, using bonds of the same investment quality. It is generally expected that long-term interest rates will be higher than short-term interest rates (i.e., a greater risk is associated with investing funds for a longer term and a higher return is required). Thus, a yield curve depicting long-term rates that are higher than short-term rates is said to be a normal yield curve (also known as a "positive yield curve"); whereas a yield curve depicting long-term rates that are lower than short-term rates is said to be an inverted yield curve (also known as a "negative yield curve"). It is believed that changes in the yield curve indicate turning points in the business cycle (e.g., an inversion of the yield curve is a precursor of a recession).
Yields on debt instruments of lower quality are expressed in terms of a spread relative to the default-free yield curve. The spread-to-Treasury is the difference between the yield on a lower quality debt instrument to the yield on a Treasury security of a similar maturity. For example, if a 10-year Treasury note yields 4.25% and a 10-year corporate note yields 5.00%, the spread is 75 basis points. Knowing the spread enables the investor to judge whether the lower quality security is paying an "adequate" risk premium (see page 71).
Market Interest Rates. Bond prices move counter to changes in market interest rates. When market interest rates go up, bond prices go down; and when market interest rates go down, bond prices go up. The longer the period to maturity, the greater the magnitude of the rise and fall of bond prices.
For example, assume a $1,000 par value bond is purchased with a coupon rate of 8%. If market interest rates stay at 8%, the market price, or value, of the bond will remain at $1,000. However, if there are 15 years to maturity, and market interest rates fall to 6%, the value of the bond will increase to $1,196. Because a purchaser will realize 2% more interest income than currently available in the market, the seller will demand a $196 premium for the bond (1,196-1,000 = 196). But if market interest rates increase to 9%, the market price of the bond will fall to $919. Because a purchaser will realize 1% less than current market interest rates, the purchaser will demand to purchase the bond at a $81 discount (1,000 - 919 = 81). But what if market interest rates fall again to 6%, but there are only 5 years to maturity? Now the price of the bond is $1,085 and the premium is only $85. Clearly, the present value of the extra 2% earnings for only 5 years is substantially less than the extra 2% earnings for 15 years. See the following page for a table containing the values used in the above graph.
Value Of A $1,000 Bond With 8% Coupon Market Interest Rates Years To Maturity 10% 9% 8% 7% 6% 1 981 991 1,000 1,009 1,019 2 965 982 1,000 1,018 1,037 3 949 974 1,000 1,027 1,054 4 935 967 1,000 1,034 1,070 5 923 960 1,000 1,042 1,085 6 911 954 1,000 1,048 1,100 7 901 949 1,000 1,055 1,113 8 892 944 1,000 1,060 1,126 9 883 939 1,000 1,066 1,138 10 875 935 1,000 1,071 1,149 11 868 931 1,000 1,076 1,159 12 862 928 1,000 1,080 1,169 13 856 924 1,000 1,084 1,179 14 851 921 1,000 1,088 1,188 15 846 919 1,000 1,092 1,196 16 842 916 1,000 1,095 1,204 17 838 914 1,000 1,099 1,211 18 835 912 1,000 1,101 1,218 19 831 910 1,000 1,104 1,225 20 828 908 1,000 1,107 1,231 Percent Loss/Gain Of A $1,000 Bond With 8% Coupon Market Interest Rates Years To Maturity 10% 9% 8% 7% 6% 1 1.9% loss 0.9% loss 0 0.9% gain 1.9% gain 5 7.7% loss 4.0% loss 0 4.2% gain 8.5% gain 10 12.5% loss 6.5% loss 0 7.1% gain 14.9% gain 15 15.4% loss 8.1% loss 0 9.2% gain 19.6% gain 20 17.2% loss 9.2% loss 0 10.7% gain 23.1% gain
Calculating Bond Prices. The price of a bond can be calculated by determining the present value of the stream of interest payments plus the present value of the bond's redemption (par) value. This is expressed in the following formula, where the Present Value Of Annuity represents the present value of the interest payments, and the Present Value Of A Single Sum represents the present value of the amount that will be received when the bond is redeemed. Note that in order to reflect the fact that bonds pay interest every six months, the market interest rate (i) is divided by 2 and the years to maturity (n) is multiplied by 2 (i.e., the interest rate is one-half the annual rate and the number of periods is equal to the number of 6-month periods). For example, a 15-year 9% bond pays 4.5% interest every 6 months for 15 years (i.e., thirty 6-month periods). (See also the discussions of the present value of a single sum on page 78, and the present value of an ordinary annuity on page 81.)
PP = Present Value Of An Annuity + Present Value Of A Single Sum
PP = A 1(1 - [(1/[(1 + i).sup.n])]/i) + , par/(1 + [i.sup.n])
PP = purchase price
A = semiannual interest payment (coupon)
i = market interest rate / 2
n = years to maturity x 2
par = face value of bond (par value)
Assume that we have a $1,000 bond that will mature in 15 years that has an 8% coupon (i.e., it pays $80 per year in interest). Assume also that we want to pay a price that will result in the bond yielding 9% to maturity. We can use the above formula to determine the purchase price.
PP = 40 (1 - [(1/[(1 + .045).sup.30])]/.045) + 1,000/[(1 + .045).sup.30]
PP = 40 (1 - [(1/3.745318)]/.045) + 1,000/3.745318
PP = 40 (1 - .267000/.045) + 267
PP = 919
Nominal Yield. This is also referred to as the "stated yield," "coupon yield," or "coupon rate." See the discussion of "coupon rate" on page 94.
Current Yield. This is the annual (coupon) interest payment divided by the current (market) price of the bond. The formula is:
Current Yield = Annual Interest Payment/Current Price
When purchasing an outstanding bond issue on the secondary market, the current yield is not necessarily an accurate measure of the investment value of a bond, since it ignores any difference between the bond's face value and the current price. In effect, it fails to account for the bond's maturity date and the premium paid or the discount received when the bond is purchased at the current market price. The following table summarizes the three possible scenarios involving current yield calculations.
Limitation Of Current Yield Face Current Current Value Price Yield Analysis $1,000 $930 70/930 = 7.53 Current yield fails to recognize that the investor pays $70 less than par, and will receive a $70 gain when the bond is redeemed for $1,000. $1,000 $1,000 70/1,000 = 7.00 Current yield accurately reflects the investment value of bond; the investor will have no gain or loss when the bond is redeemed for $1,000. $1,000 $1,040 70/1,040 = 6.73 Current yield fails to recognize investor pays $40 more than par and will suffer a $40 loss when the bond is redeemed for $1,000. The above assumes a par $1,000 bond with 7.00% coupon paying $70 interest per year.
Yield To Maturity. Because it calculates the total return, yield to maturity is a more meaningful measure of a bond's investment value than current yield (see above). Use of yield to maturity also allows for comparison of bonds with different maturities and coupons, since it accounts for both interest income and any gain or loss when the bond is redeemed.
The variable "i" in the following formula, as used on page 100 to calculate a bond's purchase price, represents the yield to maturity figure that investors most often want to determine:
PP = A (1 - [(1/[(1 + i).sup.n])]/i) + par/[(1 + i).sup.n]
With a computer program the value for i can be solved using a process of trial and error, but it is very difficult to use the above formula, or any other mathematical methods, to directly solve for "i" (i.e., the interest rate representing the yield to maturity). Absent application of a computer driven program, the following formula can be used to solve for the approximate yield to maturity. (6)
Approximate Yield To Maturity = A + [(par - PP/n)]/[(PP + par/2)]
A = annual interest payment (coupon)
par = face value of bond (par value)
PP = purchase price
n = years to maturity
Assume that we have a $1,000 bond that will mature in 9 years and has a 7% coupon (i.e., it pays $70 per year in interest). Assume also that we have paid $937 for the bond. The approximate yield to maturity is calculated as follows:
Approximate Yield To Maturity = 70 + [(1,000 - 937/9)]/[(937 + 1,000/2)]
Approximate Yield To Maturity = 77/968.50
Approximate Yield To Maturity = .0795 or 7.95%
Note that this represents a deviation from the true yield to maturity of .05 of 1% (.0800 - .0795 = .0005). In dollar terms .0005 x $1,000 = 50 cents. (Not all that bad for an approximate calculation.)
Yield To First Call. This is the annual yield considering both the yearly interest payments and any gain or loss upon redemption of the bond, but it is assumed that the issuer will call the bond at the earliest date allowed under the bond indenture. Yield to call is calculated the same way as yield to maturity, only the "number of years" figure is reduced to reflect the years remaining to the first call date. This is an important consideration if an investor is considering purchasing a bond at a premium (i.e., for more than the bond's par value). For example, assume an investor paid $1,040 for a $1,000 par value bond with a 7% coupon. Over the next year the investor receives $70 of interest. If the bond were then called by the issuer at par value the investor would receive only $1,000 for a bond that had been purchased one year earlier for $1,040. This loss of $40 will substantially reduce the investor's yield on the bond. Yield to first call considers both the interest payments received and the loss suffered upon early redemption of the bond.
Annual Rate Of Return. This is the amount that a bondholder receives from a bond divided by the amount invested, considering yearly interest payments and any gain or loss upon sale. It is the same as "yield to maturity" if the bond is held to maturity, and the same as "yield to first call" if the bond is called by the issuer at the earliest date allowed under the bond indenture. However, calculation of the annual rate of return is useful if the bondholder sells the bond prior to maturity. For example, assume an investor pays $1,040 for a $1,000 par value bond with a 7% coupon. Over the next four years the investor receives $280 of interest (4 x 70 = 280). If the investor then sells the bond for $1,025 the investor receives $15 less than paid for the bond (1,040 - 1,025 = 15). Annual rate of return reflects the $280 of interest payments and the $15 loss on sale of the bond.
BOND RISK & RATINGS
Bonds can vary substantially in their degree of risk, from United States Treasury securities that are considered without risk, to junk bonds that are considered highly speculative. In particular, credit quality is an important factor in valuing long-term bonds whose issuers are expected to meet payments over many years in the future.
Rating services such as Standard & Poor's, Moody's, and Fitch assign credit ratings to individual bond issues based upon their research into the issuer's management, financial soundness, creditworthiness, debt characteristics, and the specific revenue sources securing the bond (see the table of Bond Credit Ratings on page 104). The highest ratings are AAA (S&P and Fitch) and Aaa (Moody's), whereas the lowest ratings are DD (S&P and Fitch) and C (Moody's). Bonds rated BBB and higher are considered investment grade, whereas bonds rated BB and below are considered below investment grade (see Junk Bonds, page 106). The key question being addressed in the rating process is whether the issuer will be able to meet its regularly scheduled interest payments and the payment of bond principal upon maturity.
Credit ratings that are given to individual bond issues directly impact the amount of the coupon (i.e., rate of interest). Rating agencies not only assign ratings when a bond is issued, but also monitor developments during the bond's lifetime and will (occasionally) downgrade or upgrade a bond before maturity. Rating agencies will typically signal that they are considering a rating change by placing the bond on CreditWatch (S&P), Under Review (Moody's), or on Rating Watch (Fitch). Any changes will impact the market price of the affected bond.
Bond Credit Ratings Standard & Moody's Fitch Poor's Investment Grade Highest quality AAA Aaa AAA High quality (very strong) AA Aa AA Upper medium grade (strong) A A A Medium grade BBB Baa BBB Below Investment Grade Somewhat speculative BB Ba BB Speculative B B B Highly speculative CCC Caa CCC Most speculative CC Ca CC Imminent default C C C Default D C D Some ratings may be modified by a plus (+) or minus (-) sign or numerical designators in order to show further relative standings within a major rating category. Each of these services maintains a web site that provides useful additional information. Although access to some portions of these sites may be restricted to paying clients, a great deal of information is available to the general public (signing up with a username and password may be required). Standard & Poor's--www.standardandpoors.com Moody's--www.moodys.com Fitch--www.fitchratings.com
Bond Insurance. The credit quality of a bond issue can be enhanced by bond insurance issued by specialized insurance firms that guarantee the timely payments of interest and principal. These insurance firms are rated by one or more nationally recognized rating agencies and the insured bonds receive the same rating as the insurance firms. In the past, bond insurance was most often used with municipal bonds, mortgage bonds, and other asset-backed securities, but it is now being expanded to other securities.
Types Of Corporate Bonds. Unlike government bonds, corporate bonds contain an element of default risk, which varies according to the issuer (see page 17). Some bonds are secured, while others are unsecured and the ability to make timely payments of interest and principal depends upon the creditworthiness of the company issuing the bonds. In general, senior bonds are backed by some type of collateral, whereas junior bonds are backed by only the good faith and credit of the issuer. A large variety of corporate bonds are sold or auctioned on the initial issue market and traded on the secondary markets.
(1) Callable bonds can be "retired" by the issuer before their scheduled maturity date. The specific call provisions are set forth in the bond indenture (see Indenture, page 95). These provisions may stipulate a required time delay after the original issue date during which the bond is not vulnerable to being called. Furthermore, if a bond is called the issuer may be required to pay the bondholder a call premium above the par value of the bond (see Par Value, page 95). The process of recalling a bond is referred to as a redemption. It is then said that the bond has been called away. Bonds are typically called when interest rates have fallen to a point that the issuer will save money by issuing new bonds with lower coupons (interest rates). In fact, the process is similar to when a homeowner refinances his home mortgage at a lower interest rate. Callable bonds involve an interest rate risk, because the bondholder whose bonds have been called away is faced with having to reinvest the proceeds at lower rates of interest than those paid on the original issue. This feature is an important consideration in selecting bonds, and it is clearly indicated in bond listings (see page 109).
(2) Collateral trust bonds are similar to mortgage bonds but are secured by collateral such as other bonds, notes, or stocks.
(3) Convertible bonds offer bondholders the opportunity to exchange their bonds for a specific number of shares of the issuer's common stock. In exchange for this conversion feature, the bonds generally carry a lower coupon (interest rate). The terms of conversion, such as the price of the stock, are established when the bonds are issued. Although conversion is at the discretion of the bondholder, the decision can be forced (e.g., a bond containing a call option is called in a low-interest market). Investors purchase convertible bonds because of their added flexibility. For example, if the issuer's stock increases in price, the bond will increase in value. The bondholder can then chose to either convert the bond to stock or sell the bond at the higher price. Zero coupon convertible bonds are also issued (see page 107).
(4) Debentures are the most common form of bond. These bonds are unsecured and give the bondholder the status of a general creditor who is subordinate to the claims of secured creditors. Despite this subordinate status, debentures are generally considered high quality investments provided the issuer enjoys a high credit rating from the rating agencies (see page 103).
(5) Equipment trust certificates are issued by a trust (the lessor) that is formed to purchase specific assets and lease them to a lessee (e.g., purchase of a freight car that is leased to a railroad). Once the certificates have been repaid the lessee takes title to the equipment.
(6) Guaranteed bonds are guaranteed by someone other than the issuer. Typically the guarantee extends to interest and principal payments. With corporate bonds, the guarantor is often an affiliate or parent company; with government bonds the guarantor can be another government agency.
(7) Income bonds provide for interest payments that are contingent upon the issuer's earnings, but typically guarantee repayment of principal. In this sense income bonds are similar to preferred stock. These bonds are generally not investment grade, and are often used after a business has been reorganized due to financial difficulties.
(8) Junk bonds, also referred to as high yield bonds, hese bonds carry ratings below BBB from Standard & Poor's or Baa from Moody's (see pages 103-104). They are considered speculative and, therefore, entail a relatively high default risk (see page 17). Junk bonds are often less liquid then investment grade bonds. Junk bonds may be originally issued with below investment grade ratings, or junk status can result from a decline from an original investment grade rating (see "Fallen Angel," page 95). In order to attract investors, junk bonds will typically offer interest rates that are from three to four percentage points higher than safer government issues (i.e., 300 to 400 basis points). This difference is known as the "yield spread" (see page 96).
(9) Mortgage bonds are secured by a mortgage lien against the issuer's real property (e.g., a mortgage against property interests of a utility company). The mortgage lien can be a senior or a junior lien.
(10) Original Issue Discount (OID). This is a bond that is issued at a price that is less than its par, or maturity value (the principal amount). OID is considered to be a form of interest that must be reported as income over the life of the bond. Both corporate and Treasury bonds are available as OID securities. A debt instrument that pays no interest prior to maturity, such as a zero coupon bond, is presumed to be issued at a discount. When a bond is purchased at a market price that is lower than par and lower than its issue price, the discount is referred to as a "market discount."
(11) Participation bonds provide for a minimum coupon (interest rate), but then make additional interest payments based upon the issuer's earnings. In contrast, convertible bonds allow the bondholder to participate in the issuer's earnings growth by purchasing stock.
(12) Zero Coupon Bonds. Unlike bonds that pay interest every six months, these bonds pay no interest until maturity. (In bondspeak, they are said to have no "periodic coupon.") When issued, zero coupon bonds are sold at a deep discount from face (par) value, and upon maturity the amount redeemed is equal to face value, typically $1,000. For example, a 10-year zero coupon bond might be issued at a purchase price of $725. No interest would be paid until maturity, at which time the $1,000 redemption payment would represent a return of principal of $725, plus accrued interest of $275, compounded semiannually. Another variation of zero coupon bonds is created from bonds that are originally issued as interest paying bonds, but are then subsequently stripped of their coupons and resold as zero coupon bonds.
For the 10 most actively traded high yield bonds, as reported to the Financial Industry Regulatory Authority (FINRA), go to http://apps.finra.org/ regulatory_systems/ traceaggregates/1/.
The semiannual reinvestment of interest works to the bondholder's advantage when interest rates fall (because accrued interest is reinvested at a higher rate then currently available), but can also work to the bondholder's disadvantage when interest rates rise (because accrued interest is invested at a lower rate then currently available). This feature causes zero coupon bonds to be far more volatile in the secondary markets then coupon (interest paying) bonds. The bondholder is required to pay income taxes annually on the accrued interest, even though no interest is received during the life of the bond. However, federal income taxes can be deferred by purchasing zero coupon bonds within a qualified retirement plan, or avoided by purchasing zero coupon municipal bonds (see page 120). As with coupon bonds, zero coupon bonds are issued with call and conversion features (see pages 94 and 105). Zero coupon bonds are issued by corporations, municipalities, and the United States Treasury.
Taxation Of Corporate Bonds. From a corporation's perspective, the interest payments made to bondholders have the advantage of being deductible for federal income tax purposes, whereas dividends paid to stockholders are nondeductible. From the investor's perspective, interest payments are included in income at ordinary income tax rates, but any gain on the sale of a bond held for more than one year offers the advantage of being taxed at lower long-term capital gains rates. Also, if a bond is purchased for less than its maturity (par) value, the excess of the amount received at maturity over the purchase price is treated as long-term capital gain (provided the bond has been held for over one year).
The Securities Industry and Financial Markets Association offers an excellent online resource for information about bonds at: www. investinginbonds.com.
Tracking Availability & Performance. Corporate bond prices are printed daily in newspapers throughout the country (see page 110 for an example from Barron's). Typically these consist of tables of representative bond prices from recent bond trading. However, it is important to recognize that the bond market is primarily a dynamic, over-the-counter market in which bond prices are negotiated continually throughout the day. Going online offers a very easy way to appreciate the dynamic nature of this market. The bond quotation below contains the essential information needed by an investor who is contemplating purchase of corporate bonds, except for the specific markup or sales charge. The markup is included in the quoted price and varies according to the dealer.
The quotation above was obtained on June 14,2002. The bond was issued by May Department Stores Company with a maturity of July 15,2026, and a coupon of 8.3%. It is rated A2 by Moody's and A+ by Standard & Poor's. Purchasing the bond at the current price of 109.000% of face (i.e., 11,090 each) would produce a yield to maturity of 7.487%. However, this bond is callable, with the first call date being July 15, 2006. If it were called on that date at a redemption price of 104.150 percent of face (i.e., $1,041.50 for a $1,000 par bond), the yield to call would be 6.643%. If it were not called on July 15, 2006, the next call date would be July 15, 2007. If then called at $1,037.35 per $1,000 par bond, the yield to call would be 6.799%. The total price for 20 bonds is $22,560.11, consisting of: a principal payment of $21,800.00; accrued interest of $710.11; and a miscellaneous fee of $50.00 charged on orders of less than 100 bonds. The first coupon payment was on January 15, 1997; therefore, interest is payable on January 15 and July 15. If 20 bonds were purchased, the semiannual interest payment would be $830 (1,000 x .083 = 83 / 2 = 41.50 x 20 = 830).
The following is a typical listing of representative corporate bond sales as reported daily in Barron's.
United States Treasury securities, also referred to as "Treasuries," include Treasury bills, notes, and bonds. These are debt instruments issued by the United States Treasury to raise the money needed to operate the federal government and to pay off maturing obligations. They are considered a safe and secure investment option because the full faith and credit of the United States government guarantees that interest and principal payments will be made on time. Treasury bills, notes, and bonds (but not U.S. savings bonds) are classified as "marketable securities" because after they are issued they can be sold prior to maturity in the secondary market at prevailing market prices.
Treasury Bills. Also referred to as "T-bills," these are short-term securities that mature in one year or less from their issue date. T-bills are purchased at a discount (i.e., for a price less than their par (face) value). When they mature, the par value is paid to the investor (see page 95). For example, if a 26-week $10,000 T-bill is bought for $9,750 and held until maturity, the investor would receive interest of $250. Instead of receiving interest payments the T-bill purchaser pays less than the par (face) value and receives | the full face amount upon maturity (i.e., T-bills are purchased at a discount). There are two ways of calculating the interest rate--the discount rate and the coupon-equivalent yield (see page 113).
Recent discount rates and yields for 3-month and 6-month T-bills can be found at www. bloomberg.com/markets/ratesbonds/government-bonds/us/.
Treasury Notes And Bonds. These securities pay a fixed rate of interest every six months until the maturity date, when the fixed, or inflation-adjusted, principal is paid. The Treasury issues two kinds of notes and bonds--fixed-principal and inflation-indexed (see page 112). The only difference between notes and bonds is their length until maturity. Treasury notes mature in more than a year, but not more than 10 years from their issue date. Bonds, on the other hand, mature in more than 10 years. Notes and bonds are typically purchased for a price close to their par value. In February of 2006 the Treasury held its first auction of the 30-year bond since August of 2001. Before reintroduction of the 30-year bond, the 20-year TIPS were the longest dated marketable '? security issued by the Treasury. In the past, the 30-year bond had served as an important benchmark by which other long-dated securities were measured.
Recent coupon rates, maturity dates, current prices, and yields, for 2-year, 3-year, 5-year, 7-year, and 10-year notes, and 30-year bonds, can be found at www.bloomberg.com/markets/ rates-bonds/government-bonds/us/.
Matrix--Treasury Bills, Notes & Bonds Interest Rate & How Paid Maturities Taxation Treasury Sold at a 1 year and 1. Not subject Bills discount with under, but to state or (T-bills) the rate currently most local income determined at auctions offer taxes. weekly maturities of auctions. 4-weeks, 13- weeks, 26- 2. Included in weeks, and 52- federal income weeks. taxes upon maturity, or earlier if sold on secondary market. Treasury Interest is Current 1. Not subject Notes paid every 6 maturities to state or months. offered are 2- local income years, 3- taxes. years, 5- years, 7- 2. Included in years, and 10- federal income years. Other taxes as maturities are interest is available on paid. secondary market. Treasury Interest is Over 10 years, 1. Not subject Bonds paid every 6 but currently to state or months. only 30-year local income bonds are taxes. auctioned, with auctions to be 2. Included in held in federal income February, May, taxes as August, and interest is November of paid. 2008. Existing bonds are available on secondary market. The minimum issue amount of any Treasury bill, note, or bond is $100. Additional amounts must be in multiples of $100. The price is set at the average of competitive bids accepted. Treasury bills, notes, and bonds can be purchased in a number of different ways. New issues can be purchased by bid (noncompetitive "tender" offer) placed directly with the government in a program called Treasury Direct (see page 94), or placed through brokers, dealers, or financial institutions, in what is called the Commercial Book-Entry System (see page 93). Previously issued securities can be bought and sold on the secondary market through brokers, dealers, or financial institutions. Provided the bondholder is a Treasury Direct customer, previously issued securities can also be sold thought a government program known as SellDirect. For additional information see: http://www.treasurydirect. gov/indiv/indiv.htm.This material contains a wealth of information.
Treasury Inflation-Protection Securities (TIPS). Also called "Treasury Inflation-Indexed Securities," TIPS are a special type of Treasury notes and bonds intended to avoid loss of value due to inflation. As with other Treasury notes and bonds, TIPS make semi-annual interest payments and pay principal when the security matures. However, unlike other Treasury notes and bonds, the interest and redemption payments for TIPS are tied to inflation. The principal value of a TIPS is adjusted based on the Consumer Price Index. At maturity the security is redeemed at the greater of its inflation-adjusted principal amount or its par value. Therefore, in the unlikely event of deflation, the redemption amount cannot be less than the amount paid for the security. TIPS pay a fixed rate of interest, but this rate is applied not to the par amount of the security, but to the inflation-adjusted principal. If inflation occurs throughout the life of the security, interest payments will increase. However, in the event of deflation, interest payments could decrease. Specifically, each interest payment is calculated by multiplying the inflation-indexed principal (regardless of whether it's greater or less than the par value) by one-half the fixed interest rate as determined at auction.
For example, assume a TIP was issued with a par value of $1,000 and an annual interest rate of 4.6%. Also assume that during the first year the CPI increased by 3.4%. Without inflation-indexing, the semi-annual interest payment would be $23.00 (1,000 x .046 = 46.00 4 2 = 23.00). However, with inflation indexing the inflation-indexed principal would be $1,034 (1,000 x 1.034 = 1,034). Applying the annual interest rate of 4.6% to this inflation-indexed principal produces a semi-annual interest payment of $23.78 (1,034 x .046 = 47.56 4 2 = 23.78). Currently, the Treasury auctions 5-year, 10-year, and 30-year TIPS. (7) The auction schedule for the upcoming quarter is tentatively announced at a press conference which usually occurs on the first Wednesday in February, May, August, and November. TIPS may also be purchased through TreasuryDirect or the Commercial Book-Entry System (see pages 93 and 94). Like other Treasury notes and bonds, TIPS are exempt from state and local taxes. However, both interest income and any inflation-adjusted increase in principal are subject to federal income taxes.
STRIPs. Also known as "zero-coupon securities," these are Treasury securities that do not make periodic interest payments. Market participants create STRIPs by separating the interest and principal parts of a Treasury note or bond. For example, a 10-year Treasury note consists of 20 interest payments, one every six months for 10 years, and a principal payment payable at maturity. When this security is "stripped," each of the 20 interest payments and the principal payment become separate securities and can be held and transferred separately. STRIPS can only be bought and sold through a financial institution, broker, or dealer and are held in the commercial book-entry system (see page 93).
Measuring Returns. Generally one of two methods is used to measure the returns on Treasury bonds and notes.
(1) Discount Rate. Also known as the "discount yield," this method of calculating the interest rate divides the annual interest received by the face value. For example, if the interest was $500 and the face was $10,000 then the discount rate would be 5% (500 4 10,000 = .05). Typically used in newspaper reports, this method understates the actual yield.
(2) Coupon-Equivalent Yield. This is a more accurate method of calculating the interest rate; it is determined by dividing the annual interest received by the amount actually paid. For example, if the interest was $500 and the amount paid was $9,500, then the coupon equivalent yield would be 5.26% (500 / 9,500 = .0526). To calculate the coupon equivalent yield for 13-week and 26-week T-bills an appropriate time multiplier must be used.
Treasury Auctions. All Treasury issues, except savings bonds, are sold at public auction. At Treasury auctions, all successful bidders are awarded securities at the same price, which is the price equal to the highest rate or yield of the competitive bids accepted. Approximately one week before each auction, a press release is issued announcing the type of security being sold, the amount being sold, the auction date, and other pertinent information. Many newspapers also report Treasury auction schedules in their financial sections. To participate in an auction, a bid may be submitted either "noncompetitively" or "competitively." An investor who bids noncompetitively receives the full amount of the security requested at the return as determined at that auction, but noncompetitive bids are limited to $1 million in Treasury bill auctions and $5 million in Treasury note or bond auctions. Most individual investors bid noncompetitively.
Bid And Ask Prices. The bid and ask prices of Treasury bonds and notes are often referred to in 32nds. The following table provides the decimal equivalents.
Decimal Equivalents Of 32nds # 32nds Decimal 1 0.03125 2 0.06250 3 0.09375 4 0.12500 5 0.15625 6 0.18750 7 0.21875 8 0.25000 9 0.28125 10 0.31250 11 0.34375 12 0.37500 13 0.40625 14 0.43750 15 0.46875 16 0.50000 17 0.53125 18 0.56250 19 0.59375 20 0.62500 21 0.65625 22 0.68750 23 0.71875 24 0.75000 25 0.78125 26 0.81250 27 0.84375 28 0.87500 29 0.90625 30 0.93750 31 0.96875 32 1.00000
Tracking Availability & Performance. Prices of Treasury issues are given daily in newspapers throughout the country. Typically these consist of representative tables of bond prices from recent bond trading. However, it is important to recognize that the bond market is primarily a dynamic over-the-counter market in which bond prices are negotiated continually throughout the day. As with corporate bonds, going online offers a very easy way to appreciate the dynamic nature of this market. The following bond quotation contains the essential information needed by an investor contemplating a purchase of bonds.
The above quotation was obtained on June 21, 2002. This 30-year Treasury bond was issued on November 15, 1998, with a maturity of November 15, 2028, and a coupon of 5.25%. Purchasing the bond at the current price of 96.526% of face (i.e., $965.26 each) would produce a yield to maturity of 5.501%. The bond is not callable. For 50 bonds the total price of $48,598.33 consists of a principal payment of $48,263.00 and accrued interest of $285.33. According to the dealer, the markup is included in the quoted price, except for a miscellaneous fee of $50.00, which is charged on orders of less than 100 bonds. The first coupon payment was on May 15, 1999; therefore interest is payable on May 15 and November 15. If 50 bonds were purchased, the semiannual interest payment would be $1,312.50 (1,000 x .0525 = 52.50 / 2 = 26.25 x 50 = 1,312.50). The current yield of 5.439% is determined by dividing the annual interest payment by the purchase price (52.50 / 965.26 = .05439). Because the bond can be purchased at a discount from face, the yield to maturity of 5.501% is higher than the coupon of 5.25%. See Yield To Maturity on page 102.
Treasury Bills. The following is a listing of representative over-the-counter T-bill sales of $1,000,000 or more as reported in The Wall Street Journal online Markets Data Center (Treasury note sales are listed separately, see page 117).
Treasury Notes. The following is a listing of representative over-the-counter government note sales of $1,000,000 or more as reported in The Wall Street Journal online Market Data Center (Treasury bill sales are listed separately, see page 116).
Treasury Bonds vs. Savings Bonds. Both of these bonds are issued by the Department of the Treasury, but they are not the same. One of the primary differences is that Treasury bonds are marketable and savings bonds are not; that is, the owner of a Treasury bond can sell his bond prior to maturity, but the owner of a savings bond cannot transfer his security. Reference to a "Treasury bond" means a marketable security, not a savings bond. Also, reference to "Treasury securities" means only marketable Treasury securities. Treasury securities can be purchased on the secondary market; savings bonds cannot. Since 1986, all securities issued by the Treasury Department have been book-entry, meaning they exist only as electronic records in computers. Savings bonds are currently available in both electronic and paper format. Electronic purchases can be made through an online account using TreasuryDirect.gov or through employer payroll deduction plans. Paper savings bonds can be purchased through either local financial institutions or payroll deduction plans.
Savings Bonds. Savings bonds are Treasury issues that are payable to only the person to whom they are registered. They are not negotiable. Savings bonds can be purchased for as little as $25 and can earn interest for up to 30 years; but they can be cashed 12 months after purchase (6 months for bonds purchased before February 1, 2003).
(1) Series E/EE Bonds. These bonds and savings notes are accrual securities. As the investor holds these bonds, interest is periodically added to the amount that was originally paid, to establish the current redemption value. As this interest accrues the value of the bond increases. EE bonds issued on and after May 1, 2005, earn a fixed rate of interest for the 30-year life of the bond (interest on EE bonds issued prior to that date is not fixed, see table on page 119). For EE bonds issued from November 2010 through April 2011 the fixed rate is 0.60%. When the investor cashes an E/EE bond or savings note, he receives the redemption value, which represents the return of his original investment, plus the interest earned while he held the bond.
(2) I Bonds. I Bonds are a type of bond designed for investors seeking to protect the purchasing power of their investments and earn a guaranteed real rate of return. I Bonds are an accrual-type security, meaning interest is added to the bond monthly and paid when the bond is cashed. I Bonds are sold at face value and grow in value with inflation-indexed earnings for up to 30 years. The chart below provides an overview of the major differences between EE Bonds and I Bonds.
(3) Series H/HH Bonds. These bonds are no longer available for purchase or exchange. Series H bonds were issued from June 1952 through December of 1979, whereas Series HH bonds were issued from January 1980 to August of 2004. (Prior to August 31, 2004, Series HH bonds could be purchased for cash, or acquired in exchange for Series EE/E bonds, or upon reinvestment of the proceeds of matured Series H bonds,) Outstanding HH bonds are current-income securities, and unlike EE bonds, the bond itself does not increase in value. A fixed rate of interest is paid every six months.
Comparison--I Bonds vs. EE Bonds I Bonds EE Bonds Denominations Any amount over $25, Any amount over $25, including penny including penny increments (except increments(except paper I Bonds which paper EE Bonds which are offered in are offered in denominations of denominations of $50, $75, $100, $50, $75, $100, $200, $500, $1,000, $200, $500, $1,000, and $5,000). $5,000 and $10,000). Purchase Face value. Face value (except Price paper EE Bonds are purchased for 50% of their face value, meaning that they take longer to mature since their value is based on interest rates; but they are guaranteed to reach face value in 20 years). Purchase $5,000 per Social $5,000 per Social Limit Security Number (but Security Number (but an additional $5,000 an additional $5,000 in paper I Bonds can in paper EE Bonds be purchased, per can be purchased, Social Security per Social Security number). number). Interest * Calculated as * Bonds issued after Earnings earning a fixed rate May 2005 earn a of return and a fixed rate of variable semiannual return. inflation rated based on CPI-U. * Interest compounds * Variable rates for semiannually for 30 bonds bought from years. May 1997 through April 2005 is based on 90% of the 6-month averages of 5-year Treasury Securities yields. * Interest compounds semiannually for 30 years. Redemption Can be redeemed Can be redeemed after 12 months. after 12 months. Early 3-month interest 3-month interest Redemption penalty if redeemed penalty if redeemed Penalties during the first 5 during the first 5 years. years. Taxes * Exempt from state * Exempt from state and local income and local income tax. tax. * Treasury Direct * Treasury Direct reports interest reports interest earnings; an online earnings; an online 1099-INT shows 1099-INT shows interest reportable interest reportable for tax purposes. for tax purposes. * Tax benefits * Tax benefits available when used available when used for education for education expenses. expenses. Source: www.treasurydirect.gov/indiv/research/indepth/ebonds/ res_e_bonds_eecomparison.htm.
Municipal bonds, also referred to as "tax-exempt bonds," are issued by states, counties, cities, and other political units in order to fund a variety of projects. The main attraction for the investor of "munis" has been the exemption from federal, and sometimes, state income taxes. Because munis typically pay lower coupon rates, they are most attractive to high-income investors whose after-tax return will be higher despite lower rates of interest (see table of Equivalent Taxable Yields on page 122). As with corporate bonds, municipal bonds often have call provisions, meaning that bonds with coupon rates exceeding market rates are likely to be redeemed by their issuer.
A survey of current national municipal bond yields can be found at: www.bloomberg.com/ markets/rates-bonds/ government-bonds/us/.
Types Of Municipal Bonds. The two basic categories of municipal bonds are general-obligation bonds and revenue bonds. The general-obligation bond, also referred to as a "full faith and credit bond," is backed by the taxing authority of the issuer. If the taxing power of the issuer is subject to a legal limit, then the general obligation bond is known as a limited tax bond. When there is no such limit, the general obligation bond is referred to as an unlimited tax bond. In contrast to the general obligation bond, the revenue bond relies upon income produced by the underlying project to pay bond principal and interest. The industrial development bond is a variation of the revenue bond issued by development agencies as established by local authorities. This bond is secured only by the lease payments made by a corporation for use of the underlying facility. Industrial development bonds issued after 1987 may be subject to federal income taxes, unless they are used to fund civic services, such as pollution control facilities and airports.
Municipal Bond Ratings & Insurance. Many municipal bonds are rated by the same rating services that rate corporate bonds (see page 103). As with corporate ratings, a bond rating of BB and below is considered below investment grade, whereas a bond rating of BBB, Baa, or better is considered "investment grade." Investment grade municipal bonds are generally viewed as falling between highly rated corporate bonds and government agency bonds (see table of Bond Credit Ratings on page 104). To enhance their ratings, private municipal bond insurance companies frequently insure municipal bonds. Typically these bond insurers will themselves have very high ratings of AAA or AA from the ratings services. Insurance guarantees that the bond investor will receive timely payments of both interest and principal, but it does not insure against the risk of a bond's market value falling due to increased interest rates. The investor assessing an insured municipal bond's credit worthiness would be better advised to ignore the issuer's ratings, relying instead on the insurer's rating.
Federal Taxation. Depending upon their purpose and date of issue, the interest paid on municipal bonds may or may not be tax-exempt, or subject to the alternative minimum tax. The following chart provides an overview of how interest payments are treated for federal income tax purposes. The funding examples are not all inclusive.
Profit from the purchase and sale of municipal bonds may be subject to federal taxation. For example, if a bond is purchased at a premium the premium amount must be amortized over the remaining life of the bond and this affects the bondholder's basis. The holder's basis in the bond includes the amount originally paid for the bond plus any additions to basis, such as original issue discount (OID). When the bond is sold or redeemed prior to maturity any amounts received in excess of basis are generally taxed as capital gains. These calculations can be quite complicated and the advice of tax counsel should be sought.
State Taxation. Most states and municipalities do not tax interest income received from tax-exempt bonds issued by that state, its agencies, or its political subdivisions. In contrast, virtually every state imposing an income tax also taxes interest income received from bonds issued by other states, out-of-state agencies and political subdivisions. The state exemptions for interest on in-state bonds may not extend to: (1) capital gains resulting from a sale or other disposition of the bonds; and (2) ordinary income resulting from application of the market discount rules. Again, the advice of tax counsel should be sought.
Build America Bonds. Build America Bonds (BABs) are taxable bonds issued by state and local governments that give them access to the conventional corporate debt markets. There are two types of BABs. With "Tax Credit BABs," refundable tax credits are provided directly to the bondholders. With "Direct Payment BABs," the Treasury Department makes payments to the issuers in an amount equal to 35% of the interest payments on the BABs. As a result, state and local governments have lower net borrowing costs and are able to reach more sources of borrowing than with more traditional tax-exempt bonds. For example, if a state were to issue BABs at a 10% taxable interest rate, the Treasury Department would make a payment directly to the state of 3.5% of that interest, and the state's net borrowing cost would thus be only 6.5% on a bond that actually pays 10% interest (i.e., 35% of 10% is 3.5%). Average yields to investors in these bonds have actually been a little over 6%. Unless extended, BABs can be issued only from February 17, 2009 through 2010.
Tax-Free vs. Taxable Yield Comparisons. Due to their tax-free nature, municipal bonds typically offer lower interest rates than comparable corporate and Treasury bonds. (However, in 2008 selling at historically high ratios relative to U.S. Treasuries municipal bonds actually offered higher yields than U.S. Treasuries.) Depending upon the investor's individual marginal income tax bracket, a higher interest paying taxable bond may provide more after-tax earnings than a lower interest tax-free municipal bond. The following table provides equivalent taxable yields based upon assumed tax-exempt yields in one-quarter percent increments from 2.00% to 6.00%.
Equivalent Taxable Yields 2011 Federal Income Tax Brackets Tax Exempt 15% 25% 28% 33% 35% Yield 2.00 2.35 2.67 2.78 2.99 3.08 2.25 2.65 3.00 3.13 3.36 3.46 2.50 2.94 3.33 3.47 3.73 3.85 2.75 3.24 3.67 3.82 4.10 4.23 3.00 3.53 4.00 4.17 4.48 4.62 3.25 3.82 4.33 4.51 4.85 5.00 3.50 4.12 4.67 4.86 5.22 5.38 3.75 4.41 5.00 5.21 5.60 5.77 4.00 4.71 5.33 5.56 5.97 6.15 4.25 5.00 5.67 5.90 6.34 6.54 4.50 5.29 6.00 6.25 6.72 6.92 4.75 5.59 6.33 6.60 7.09 7.31 5.00 5.88 6.67 6.94 7.46 7.69 5.25 6.18 7.00 7.29 7.84 8.08 5.50 6.47 7.33 7.64 8.21 8.46 5.75 6.76 7.67 7.99 8.58 8.85 6.00 7.06 8.00 8.33 8.96 9.23 This table assumes the investor is subject to federal income taxes only
For example, assume John, an investor in a 28% tax bracket had the choice of investing in a 4.25% tax-free municipal bond or a 6.15% Treasury bond. For John, a 4.25% tax-free yield is the same as a 5.90% taxable yield, meaning that any taxable return over 5.90% will provide greater after-tax earnings than the 4.25% tax-free return. Therefore, John would choose to invest in the taxable 6.15% Treasury bond. On the other hand, if the choice was between investing in a 4.25% tax-free municipal bond or a 5.75% Treasury bond, John would choose the 4.25% tax-free municipal bond.
When a municipal bond is also exempt from state and local income taxes it is important to consider the investor's maximum effective tax bracket including these state and local taxes. Assume Jane, an investor, is in a 28% federal tax bracket, but is also subject to an additional 6% of state income taxes, for a total maximum tax rate of 34%. The following formula can be used to determine the equivalent taxable yield for Jane, who is considering investing in a 4.25% tax-free municipal bond.
Equivalent Taxable Yield = Tax-Free Yield / 100 - Tax Bracket
Equivalent Taxable Yield = 4.25 / 100 - 34
Equivalent Taxable Yield = 4.25 / 66
Equivalent Taxable Yield = .0644 or 6.44%
A wide array of agency securities is available on the market. (8) Some are issued by federally related institutions such as the Government National Mortgage Association (GNMA), while others are issued by government-sponsored entities such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). (9) Funds are raised in one of two ways--either the agency directly issues its own securities, or the agency guarantees the timely payment of principal and interest on the indebtedness of its constituents (e.g., mortgages placed on private homes--see Mortgage-Backed Securities on page 124).
Investment Considerations. Although agency securities are generally not obligations of the federal government, some have direct government guarantees, and all are backed by various state and federal agencies. Because of this, most investors view them as having very low default risk. Agency securities have been described as "a perfectly safe investment" yet "not quite as safe as a United States Treasury security...." (10) However, as with other securities, if purchased at a premium agency securities are subject to interest rate risk (see page 17). Often these securities are also subject to prepayment risk, meaning that in the event of prepayment the investor is likely to be faced with having to reinvest proceeds at prevailing lower interest rates (similar to the bond call risk, see page 16). When compared to Treasury securities, other limitations of agency securities include high minimum purchase requirements and a more restricted resale market that can make them more difficult and expensive to trade. Short-term agency securities, similar to Treasury bills, are issued at a discount from face value and pay no interest until maturity. Long-term agency securities, similar to Treasury notes and bonds, are issued at face value and pay interest every six months. Mortgage-backed agency securities can be complicated to understand and often involve more demanding record keeping. Although interest payments are subject to federal income taxes, they may be exempt from state and local income taxes; but this should be confirmed before making an investment decision. Despite these limitations, the variety of available securities and the somewhat higher interest rates can make agency securities attractive to investors. As with other investment vehicles, mutual funds consisting of agency securities can also be purchased. Regarding the use of unit trusts and mutual funds, see Bond Funds vs. Individual Bonds on page 128.
Mortgage-Backed Securities. (11) These are securities that are secured by a pool of mortgage loans (see table on page 127). For example, issues of the Government National Mortgage Association (GNMA), commonly known as Ginnie Maes, are collections of mortgages with the same interest rate and maturity date that are secured by similar properties with similar values (e.g., single-family homes). Each mortgage pool forms the basis of a security that is purchased by investors. Mortgage-backed securities are in turn classified as either of the following:
1. Pass-throughs pass interest and principal payments to investors in direct proportion to their pro-rata interests in the pool of mortgages.
2. Collateralized Mortgage Obligations (CMOs), also known as pay-throughs, pass payments to investors according to a pre-determined schedule that can accommodate a variety of investment objectives. For example, Investor Class A might receive principal payments before Investor Class B, and Investor Class B would also receive a higher rate of interest as compensation for the delayed payments of principal (i.e., investments with longer maturities typically receive higher rates of interest). These various classes of ownership are known as tranches. While the wide diversity of CMOs makes them attractive to many investors, they can be complicated and difficult to evaluate.
The Wall Street Journal website provides a daily listing of prices, yields, and spreads of mortgage-backed securities. Go to www.wsj.com. Click on Markets tab & then on Market Data tab. Then under Bonds, Rates & Credit Markets tab, click on Mortgage-Backed Securities, CMOs (located under Quotes & Trading Statistics in drop-down box).
One disadvantage of investing in agency mortgage-backed securities is the difficulty of accurately predicting the life span of a new security. Unlike corporate and government bonds, periodic payments include both interest and principal. In a market of falling interest rates, individuals prepay and refinance their mortgages. These prepayments force holders of mortgage-backed securities to reinvest these proceeds at lower prevailing rates of interest. Unlike the investor who purchases bonds with known callable dates, the investor in mortgage-backed securities cannot predict when, if ever, mortgages will be prepaid. Prepayment rate assumptions based on average experience are used to predict cash flows. The importance of predicting prepayment rates is important, as demonstrated by the following graph.
Total Cash Total Interest Flow Payments No Prepayments $276,809 $176,809 5% Prepayments $206,559 $106,559 10% Prepayments $171,280 $71,280 15% Prepayments $151,924 $51,924
Assuming no prepayments, the investor would receive a level annual cash flow of $9,227 per year. (Of course, as with any amortization schedule, these annual payments would consist of interest and principal, with the interest payments decreasing each year and the principal payments increasing each year.) But if 5% of the outstanding mortgages were prepaid each year, the investor would receive $14,189 in year 1, decreasing to $2,085 in year 30. Assuming 10% repayment, the investor would receive $19,151 in year 1, decreasing to $435 in year 30. Assuming 15% repayment, the investor would receive $24,114 in year 1, decreasing to $83 in year 30. Total interest payments would drop from $176,809 to just $51,924.
Real Estate Mortgage Investment Conduit (REMIC). REMICs are pass-through, or flow-through, tax entities that hold mortgages secured by various types of real property, including residential and commercial properties. Many residential mortgage-backed securities guaranteed by government agencies are available as REMICs (see page 124). Most transactions in "commercial mortgage-backed securities" (CMBS) are also now structured as REMICs. They offer investment flexibility because each REMIC is designed according to specific investor needs. Cash flows from the underlying collateral are allocated to individual bonds, called tranches, of varying maturities, coupons and payment priorities. A REMIC may include any number of classes of regular interests and must include a single residual interest class. These classes are assigned a coupon (fixed, floating, or zero interest rate), and the terms and conditions for payments to the investor. The income from a "regular" interest in a REMIC is treated as interest (i.e., reporting of original issue discount or market discount is made under the rules that apply to bonds). REMICs are complex investments that require careful consideration before investing, including consideration of various tax issues. (12)
For information about REMICs available from Freddie Mac, see: www. freddiemac.com/mbs.
Non-agency securities are sold on the private-label market. They consist of non-conforming loans not normally eligible to be purchased or guaranteed by a government agency (e.g., jumbo, Alt A, or subprime mortgages). Home mortgages can be securitized by packaging them into interest-bearing securities. For example, we can trace the process as follows (from left to right below): (1) the borrower gives a mortgage to the lender in return for a loan; (2) the lender sells the mortgage to the arranger; (3) the arranger securitizes pools of mortgages and obtains ratings from credit agencies; (4) the distributor markets the product to investors; (5) the investor purchases based upon ratings assigned to the securities.
Securitization of Subprime Mortgages (1) (2) (3) (4) (5) Borrower Lender Arranger Distributor Investor Homeowner Mortgage Commercial/ Investment Institutional Company Investment Bank Financial Bank Hedge Funds
The product created by the arranger when securitizing individual mortgages is called a mortgage-backed security (MBS). When comprised entirely of loans made to subprime borrowers it is called a subprime mortgage-backed security (subprime MBS). See the discussion of subprime mortgages on page 213-214. To accommodate particular investor cash flow requirements, pools of subprime mortgages are divided into tranches (or slices) of bonds with varying maturities. In turn, investment banks repackage lower level tranches of MBSs into collateralized debt obligations (CDOs), which themselves are divided into tranches with assigned credit ratings. This is only one variation of a potentially very complex process. (It is very difficult to value MBSs and CDOs backed by subprime mortgages because they do not trade on an active market.) Loose regulatory oversight of mortgage companies leads to bad loans with little or no underwriting standards (e.g., no-doc and no down payment loans). The lender is motivated to produce mortgages that are sold for securitization, with little regard for the quality of the loan. The investor, being far removed from the borrower/lender transactions, continues to make investments relying upon ratings assigned by the rating agencies. With high demand for housing driven by easy credit, home values become over-inflated, home prices turn down, and marginal or poor credit risks fail to make their mortgage payments as adjustable mortgages reset to higher rates. This is essentially the process that leads a subprime mortgage meltdown. As a result, in 2008 issuance of private-label MBSs virtually came to a halt. (13) While non-agency securitization would appear to be good in theory, its future utilization may well depend upon simplified transactions, standardized contracts, and transparency with respect to the underlying mortgages. For example, current proposals involve subjecting the underwriting standards of securities backed by mortgages to greater supervision by the Securities and Exchange Commission, and requiring that credit default swaps be traded through a central clearinghouse or exchange.
Types Of Mortgage-Backed Securities Ginnie Freddie Freddie Mae Mac PC Mac GMC Payment Monthly; Monthly; Semi- Stream guaranteed guaranteed annually; 15-day 44-day annual delay; delay; principal periodic periodic payments prepay- prepayments ments Underlying FHA/VA Conventional Conventional Asset mortgages mortgages mortgages Guarantee Full faith Freddie Freddie and credit of Mac's net Mac's net U.S. worth; worth; Treasury private private mortgage mortgage insurance insurance on on mortgages mortgages with loan- with loan- to-value to-value over 80% over 80% Liquidity/ Active Active Less active Secondary market due market due due to high Market to high to high volume of volume of volume of issue; lower issue; risk- issue; low- issue free status risk status volume Rating/ Government Considered Same as Risk security; no nearly Freddie Mac Equivalent rating equivalent to PC required a government security; no rating Mortgage- FNMA Backed CMBS Bond Payment Monthly; Semi- Stream guaranteed annually; 25-day principal at delay; maturity or periodic sale prepayments Underlying Conventional General Asset mortgages assets Guarantee Freddie Overcolla- Mac's net teralized by worth; 150-200% private with mortgage mortgage insurance portfolio on mortgages with loan- to-value over 80% Liquidity/ Unknown at Same as Secondary this time Institutional Market PC Rating/ Same as AAA due to Risk Freddie Mac continuous Equivalent PC maintenance of position; overcolla- teralized position Source: Stephan R. Leimberg et al., The Tools and Techniques of Investment Planning, 2nd ed. (Cincinnati: The National Underwriter Company, 2006), p. 214. Bond Funds vs. Individual Bonds, UIT's & ETF's Bond Mutual Individual Funds Bonds Pros Diversification; Higher yields; fixed professional maturity dates management; liquidity Cons More expensive: Not as liquid as higher costs mean funds; investor must lower yields; no manage fixed maturity date Brief Managed portfolio Individual Description of bonds securities Maturity Date No maturity date - Set maturity date; bonds are choice of 1-30 constantly bought years and sold Income Fluctuating Semiannual, except Payments monthly payments zero coupon bonds Liquidity Sell anytime at Sell anytime at current fund value current market price; some bonds less liquid Diversification Constantly Individual chooses changing portfolio from multiple issues Management Professional Investor managed Costs Annual One-time charge at management; may purchase or sale have a load Minimum Varies among Usually $5,000, and Investment funds increments of $5,000 Reinvestment Dividends can be Investor is required reinvested to reinvest Availability Always available Limited by issue Bond Unit Investment Trusts Bond ETF's Pros Diversification; Easy to trade; fixed maturity; diversification fixed interest income Cons Not as liquid as No fixed maturity mutual funds; date; income higher sales streams charges than not always individual bonds predictable Brief Fixed portfolio of "Basket" of Description bonds held in a securities typically trust linked to an index Maturity Date Trust buys a set of No fixed maturity bonds with fixed date; therefore no maturities yield to maturity Income Investor's choice: Fluctuating Payments fixed monthly, monthly quarterly, or payments; not semiannual always payments predictable Liquidity Sell anytime at Liquid; see anytime current market during the day at price; less liquid current market than funds price Diversification Fixed diversity of Instant investments diversification Management Monitored, not Most not managed; managed managed ETF's are appearing Costs Sales charge at One time charge at purchase; annual purchase or sale; fee ongoing management fee Minimum Often $1,000 Trade as shares on Investment an exchange; prices vary Reinvestment Some trusts allow Investor must do it reinvestment Availability Can be limited by Many ETF's for trust varying strategies Source: ww.bondsonlme.conyasp/research/bondfunds.asp. Used with permission.
CROSS REFERENCES TO TAX FACTS ON INVESTMENTS (2011)
Q 7714. Is an investor who holds a T-bill required to include interest in income prior to sale or maturity of the bill?
Q 7715. How is an investor taxed on the gain or loss on the sale or maturity of a Treasury bill?
Q 7720. What does the holder of a Treasury note or bond include in annual income?
Q 7721. How are the proceeds taxed on sale or redemption of Treasury notes and bonds?
Q 7724. How are proceeds on the sale or retirement of a corporate bond taxed?
Q 7725. How is a convertible bond taxed on conversion?
Q 7729. How are inflation-indexed bonds treated for tax purposes?
Q 7732. How is gain or loss treated when a market discount bond is sold?
Q 7737. How is original issue discount on corporate and Treasury obligations issued after July 1, 1982 included in income?
Q 7744. Is interest on obligations issued by state and local governments taxable?
Q 7745. Is tax-exempt interest treated as an item of tax preference for purposes of the alternative minimum tax?
Q 7746. How is gain or loss taxed on sale or redemption of tax-exempt bonds issued by a state or local government?
Q 7747. Is premium paid for a tax-exempt bond deductible? Must basis in a tax-exempt bond be reduced by bond premium?
Q 7760. When is the interest on United States Savings Bonds Series E or EE taxed?
Q 7764. How is the owner of Series H or HH bonds taxed?
Q 7765. How is the owner of Series I bonds taxed?
Q 7767. How is the monthly payment on Ginnie Mae mortgage-backed pass-through-certificates taxed?
Q 7769. How is the owner of a REMIC interest taxed?
Donald F. Cady, J.D., LL.M., CLU
(1) Announcement in The Wall Street Journal, May 16, 2002, page C5.
(2) These include the Federal Home Loan Bank, the Federal Farm Credit Bank, and the Federal National Mortgage Association.
(3) See The Wall Street Journal, May 20, 2002, page C13.
(4) The taxation of original issue discount bonds varies according to the issue date and can be complicated. See Tax Facts On Investments (Cincinnati: The National Underwriter Company, 2011, revised annually), Question 7737.
(5) The Bond Market Association has merged with the Securities Industry Association (SIA) to form the Securities Industry and Financial Markets Association (SIFMA). See also, www.investinginbonds.com.
(6) See also Lawrence J. Gitman and Michael D. Joehnk, Personal Financial Planning, 7th ed. (Fort Worth: The Dryden Press, 1996), p. 472.
(7) In a security reopening, the U.S. Treasury issues additional amounts of a previously issued security. The reopened security has the same maturity date and coupon interest rate as the original security, but with a different issue date and usually a different purchase price.
(8) Other government-sponsored entities include the Federal Farm Credit Bank System, the Farm Credit Financial Assistance Corporation, the Federal Home Loan Bank, the Student Loan Marketing Association (Sallie Mae), and the Resolution Trust Company. For an excellent discussion of agency securities and mortgage-backed securities see Robert Zipf, How the Bond Market Works, 2nd ed. (Paramus, New Jersey: New York Institute Of Finance, 1997), p. 57.
(9) Although there are no actual guarantees, the financial markets have treated mortgage-backed securities issued by Fannie Mae and Freddie Mac as carrying the implicit backing of the federal government. The federal takeover of Fannie and Freddie by the US Treasury in September 2008 as part of the subprime mortgage crises will only add to the perception that the debts and guarantees of these government sponsored enterprises will be supported (e.g., the agreements Treasury made with both Fannie and Freddie were designed to protect their senior and subordinated debt and mortgage backed securities).
(10) See Zipf, pg. 61.
(11) A broader term, "asset-backed securities," is used to describe debt-type securities that are secured by a pool of similar debt obligations or receivables (e.g., residential mortgages, auto loans, student loans, and credit card receivables). An excellent source of information about asset-backed securities is Stephen R. Leimberg et al., Tools & Techniques 0f Investment Planning, 2nd ed. (Cincinnati: The National Underwriter Company, 2006), p. 209.
(12) See Leimberg, et al., p. 195.
(13) See "Improving the Infrastructure for Non-Agency Mortgage-Backed Securities," Governor Randall S. Kroszner, December 4, 2008, At the Federal Reserve System Conference on Housing and Mortgage Markets, Washington, D.C. (www.federalreserve.gov/newsevents/speec/kroszner20081204a.htm).
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|Title Annotation:||2011 FIELD GUIDE TO FINANCIAL PLANNING|
|Author:||Cady, Donald F.|
|Publication:||Field Guide to Financial Planning|
|Date:||Jan 1, 2011|
|Previous Article:||Chapter 6: Cash reserves & equivalents.|
|Next Article:||Chapter 8: Stocks.|